The system-wide exploratory scenario (SWES) exercise aims to assess the risks around market-based finance. It's part of the Bank of England’s biennial exploratory scenario testing, similar to the 2021 Climate Biennial Exploratory Scenario (CBES). With a focus on liquidity, the choice of topic has been inspired by last year’s gilt sell-off after the mini-budget and the 2020 ‘dash for cash’ triggered by the pandemic.
Both events highlighted how firms’ responses to market conditions can accentuate market shocks and contribute to market instability. Sudden drops in liquidity can affect individuals and businesses, impacting credit facilities, mortgage pricing and borrowing rates, among others.
As such, SWES isn’t about assessing resilience. It’s about understanding behaviour and identifying how firms would react under stressed market conditions.
What will SWES exercise participants need to do?
Working with the Financial Conduct Authority (FCA) and the Pensions Regulator (TPR), the Bank of England has created a diverse sample of insurers, banks, central counterparties (CCPs) and funds to take part. Now in its initial information-gathering stage, the SWES will consist of two parts:
1 Banks, insurers and funds will be asked to model the impact of a shock scenario and outline how they would respond to it. CCPs will report to the Bank of England regarding the impact on liquidity.
2 The Bank of England will feed the responses back into the stress scenario to see how firms’ collective actions would affect it. It will then create a revised scenario, taking into account any amplification effects.
While firms have a range of actions they might take in response to stress, the Bank of England is specifically looking at actions in relation to gilts, gilt repos, sterling corporate bonds, and their corresponding derivatives markets.
Assessing three key transmission channels
In terms of firms’ responses, SWES will look at the following three transmission channels:
1 Drivers of liquidity needs during stress
The Bank of England wants to understand what may trigger additional liquidity needs. Examples include investors redeeming from funds and requirements to post additional collateral.
2 How firms would meet additional liquidity demands
This includes selling assets, drawing on additional credit or using liquidity management tools.
3 Additional actions to deleverage, reduce exposures or rebalance portfolios
Examples include steps to limit exposures to particular counterparties or markets, or exiting some markets entirely. This would also include actions that firms need to take to comply with any mandates or internal limits they may have.
A chance to shape the SWES exercise
While the scenario is yet to be published, there are a few things to think about – notably IFRS 17. Insurers are still in the first year of implementation and the run-up to the year-end reporting cycle could prove challenging. Resources may be stretched and SWES could add further pressure for participating insurance firms.
However, this could depend on how complex the scenario is. If there are any similarities to past exercises, such as last year’s Life Insurance Stress Test, then firms could carry over their processes and methodology. But they would need to tailor their approach to the specific scenario.
During the information-gathering phase, participating firms do have the opportunity to influence the design, so there's the option to help shape an exercise that is pragmatic and adds value.
